The dollar under threat
By Martin Wolf
The Financial Times
Published: January 7 2003 20:11
The US has the most powerful military, the biggest economy and the most important currency. But it is also running a huge and growing current account deficit. This is remarkable.
In the decades before the first world war, Britain ran current account surpluses averaging about 4 per cent of gross domestic product. Last year, however, its successor as world power ran a deficit of close to 5 per cent of GDP and had net external liabilities of 25 per cent. This transfer of resources allows the sole superpower to enjoy guns and butter: the current account deficit was 50 per cent bigger than defence spending.
Since 1980, trend growth of US imports, in constant prices, has been 7.6 per cent a year, against 3.1 per cent for GDP. Over the long run, US export growth has also been faster than GDP. But there has been a sharp deterioration in recent years: between 1997 and the third quarter of 2002, trend growth of exports, in constant prices, was 2.2 per cent a year, a little below the growth in the rest of the world's GDP, at market prices. This deterioration has been partly caused by sluggishness elsewhere. But the big change is in the relationship between that growth and US exports. The worsening of export growth must have largely reflected the dollar's strength.
Now project these trends forward. Assume that the US economy grows at 3.5 per cent a year, in real terms, while the rest of the world manages to grow at 3 per cent. Assume also that exports grow in line with the rest of the world's GDP, at 3 per cent, while imports grow at 6 per cent. Then the US trade deficit rises from about $420bn in 2002 to $990bn by 2010. This is a jump from about 4 per cent of GDP to close to 7.5 per cent.
At the end of 2001, US external assets were $6,860bn, valued at market prices, while external liabilities were $9,170bn. But, surprisingly, the US ran a small surplus on investment income of $14bn. The US earnt an average of 4.1 per cent on its assets and paid out an average of only 2.9 per cent on its liabilities. Tim Congdon, of London-based Lombard Street Research, notes that the US surplus has been roughly constant since 1987, despite the deteriorating net asset position. Foreigners are stupid investors, whose stupidity has risen along with their net asset position.
It is difficult to believe this will last for ever. In projecting the net balance on investment income, I have assumed that the US continues to earn about 1 per cent more on its foreign assets than it pays on its liabilities. Then, as current account deficits pile up, so do deficits on investment income. By 2010, net investment income becomes about minus 1.1 per cent of the then GDP. If one projects net transfers abroad in line with GDP, the overall current account deficit rises to just under 9.5 per cent of GDP by 2010, when net liabilities are close to two-thirds of GDP.
The US capital stock is about three times GDP. So today foreigners own about 8 per cent. On the above assumptions, they would own a fifth of it by 2010. If all this net investment were to come from the European Union and Japan, these investments would then amount to about a sixth of their total wealth. Is it not possible that these economies, which suffer from demographic deline, poor investment opportunities and a savings surplus, would happily invest that much of their wealth in the world's biggest, most stable and most profitable advanced economy?
The difficulty with this view is twofold. First, there is well established evidence for a strong home-market bias in investment. While that may be weakening, as the world becomes used to open capital markets, it is hard to believe it is weakening quite so quickly. Second, this home-market bias makes sense. Foreigners are exposed to growing risks, particularly the exchange rate. Rationally, they should want, among other things, a good chance of a big real appreciation and not, as at present, the reverse.
For these reasons, a move away from US assets by foreign investors and so a repricing of the dollar seem highly plausible. Indeed, that has already been happening. Between 2000 and the first three quarters of 2002, foreign private purchases of US assets fell from $978bn to $560bn (at an annualised rate). Foreign direct investment fell from $308bn in 2000 to an annualised rate of just $14bn in 2002. This has also been associated with dollar weakness. Against the euro, for example, the dollar has lost 20 per cent of its value since July 2001.
The decline in the dollar is likely to be reinforced by the perceived need for the US trade deficit at least to stop growing. But the US trade deficit is large and the ratio of exports of goods and commercial services to GDP is low, at some 9 per cent of GDP. As a result, imports are about 40 per cent bigger than exports. If imports grow at 6 per cent a year and the trade deficit is to stabilise as a share of GDP, exports need to grow, over the rest of the decade, more than 7 per cent a year, in real terms. If the trade deficit is to halve, exports must grow at 9 per cent.
This needs far more than a recovery in the rest of the world. A reduction in the US trade deficit by contraction of domestic demand alone would also mean a slump. Under plausible assumptions, the absolute reduction in demand would have to be many times as big as the desired reduction in imports. If this disaster is to be avoided, the exchange rate must fall, to switch demand from imports towards domestically produced goods and switch demand in the rest of the world towards US exports.
That depreciation would also need to be large, because the US is a large economy in relation to the rest of the world, and has a small export sector in relation to its own economy. If the reduction in the US trade deficit had to be in the order of 4-5 per cent of GDP, the depreciation required might be as big as 30-50 per cent in real terms. In the short run, moreover, such a depreciation would worsen the current account. That might well create a big exchange rate overshoot.
Yet the east Asian economies, particularly China and Japan, will resist any appreciation. Japan has been accumulating reserves at an extraordinary rate: last November they were $460.5bn, up $58.5bn since the end of 2001. This leaves the euro. Again, any further appreciation would be hugely unwelcome. It could force big policy changes on the European Central Bank. But it could also create a crisis, particularly in Germany.
The superpower is living on borrowed money and borrowed time. Its rake's progress cannot continue for ever. But how and when it will end remains disturbingly obscure. |
